GDP reports for the past two quarters have been solid despite numerous issues including natural disasters, social unrest, and political drama both here and abroad.
Interest rates remain near historic lows while inflation is well contained. The employment rate continues to improve. The Fed has paid lip service to raising rates in anticipation of increased levels of inflation, which have been expected due to improved employment; yet, inflation has remained subdued at both the consumer and producer levels, making the case for higher rates difficult to justify. Factoring in the change in leadership at the Fed, as Chairwoman Yellen prepares to pass the gavel to Fed Governor Powell in early 2018, we suspect there will be no material changes in Fed policy until well into next year.
The US dollar has been in a narrow trading range versus our major global trading partners. Energy prices, likewise, have swung within a narrow range allowing consumers to take a breather and rebuild savings. Spending and savings levels, albeit not great, have been relatively consistent. Corporate profits continue to be surprisingly strong given the duration of the current economic expansion. At one point, several quarters prior, it appeared an inventory oversupply might derail the economy, but this self-corrected without significant disruption. Global economies continue to perform well from the Far East, across continental Europe, and into the Americas.
The macro-economic environment appears to be very steady with predictions of continued improvement ahead. Based on those predictions, we remain cautious and alert given historic trends and the cyclical nature of market-based economies. We think this is an opportune time to reassess overall market exposure and tolerance for increased volatility. Experience guides us to make intelligent forward-looking decisions during periods of calm and certainty, in anticipation of future periods of excitement and uncertainty.
Many of the critical issues we have written about over the past few years remain unaddressed: Fed balance sheet bloat, Congressional gridlock, excessive US Government debt levels, and burgeoning student loan/revolving credit debt levels. We think an economic slowdown at this point would be very difficult, if not impossible, to counter using traditional fiscal and monetary policy tools.
We find no evidence to conclude market pricing is efficient, in the clearest sense of the word, contrary to what many theorists and academics proclaim. In fact, over the past 20 to 30 years we have observed an increase in the level of price variability as a function of a) more participants in increasingly active markets across the globe, and b) the proliferation of information that is available to these participants on a nearly instantaneous basis.
In theory, having more participants rendering opinions as to the value of an asset (business) will lead to a convergence around the “right” price, an efficient mechanism driven by large numbers of data points. In addition, as an increasing amount of information flows freely across the globe on an instantaneous basis, allowing participants to act as informed/intelligent investors or decision makers, it would follow that the market price would coalesce around a certain price reflecting the collective judgment of the many informed participants.
It is with some regret that we can report through firsthand experience the contrary: evidence indicates the greater the flow of information, and the more rapidly it is synthesized, the greater the price variability of any security on a daily basis. The notion that many participants will arrive at the correct and nearly identical conclusion is flawed. In fact, the greater the number of participants, the wider the range of “consensus” in concluding the correct price of any asset. There are far too many examples that support this unpopular conclusion to deny its reality.
For example, Twitter, Inc. (NYSE: TWTR), a very popular and well-followed stock by investors and others around the globe, has traded as follows over the past year:
It is difficult to understand how the fair value of Twitter varied so radically over these many short-time periods. Did market participants miscalculate? Could they not agree? Were some investors more informed than others, and if so, did they have an advantage?
Even on a daily basis, when the same information is available to all investors, price volatility can be elevated, causing one to doubt the collective judgement of participants. For example, the following is an intra-day chart of LSB Industries, Inc. (NYSE: LXU) on October 31st:
Note the sharp opening price decline, based on pre-market earnings news that was available to all participants well in advance of the trading day, followed by a period of price uncertainty. The shares traded between $6.70 and $7.75 during the day, a swing of over 15% from low to high. It is doubtful the value of the business changed by 15% in one day. Some unfortunate investor interpreted the news in advance of the market open and sold, depressing the share price from $7.10 to $6.70 within minutes of the opening trade. On the market opening, the entire business was valued at $182 million with the stock trading at $6.70. By day’s end the business was valued at $210 million. This is a fairly large swing in value. It is hard to characterize this as an efficient pricing mechanism.
Many have said in the short-term prices can be irrational, but in the long-run they tend to correct and reflect a fair or accurate value. To this we counter, what is the long-run? Are we not always investing on a day-to-day, hour-to-hour, minute-to-minute basis where the last quoted price is the price? When is the long-run? We prefer to think that share prices ebb and flow above and below fair value. We believe share price fluctuates far more widely than share value or business value. We think the last quoted price is only occasionally at or near an appraised value. This is simply coincidental, not a causal relationship. On a day-to-day basis – the only period that matters in an investor’s world – price only occasionally reflects value.
If our assumptions about the lack of efficiencies in market pricing are correct, then there is an interesting opportunity for astute investors. If prices fluctuate below and above appraised/fair value, an obvious arbitrage opportunity exits.
Buy when the share price is well below fair value
Sell when the price is well above fair value
The flag on the play relates to the term fair value. What is fair value? Only a knowledgeable investor can determine this. An appraisal of fair value is derived from an analysis of the financial statements of a business enterprise along with a thorough understanding of the competitive position the business maintains. A fluency with the corporate financial statements is the critical starting point when appraising a business and establishing its fair value. Absent this analytical knowledge, a market participant degenerates into a speculator, falling from the position of an investor. Speculative market participants are more likely to experience a permanent loss of investment capital because of their own limitations.
There are few requirements to enter the “marketplace” as a participant. For the most part, if you have money/capital, you are welcome. That’s all. Show up with money and you get in. No experience or intelligence required as a precondition. Let’s assume for a moment that not everyone who shows up and offers to buy is informed or knowledgeable. If that is the case (and it is), then some participants will necessarily cause price inefficiencies by virtue of their unknowing participation.
The greater the number of uninformed or misinformed investors, the higher the variability in pricing at any given moment. This creates opportunity to buy when the share price is well below, or sell when the share price is well above, appraised value.
The issue of appraised value is critical. Appraising an asset, in this case a business, requires a high level of skill. Most participants/investors do not possess the knowledge, skill and experience to thoroughly and accurately appraise a business. In order to assess the value of a business, an investor/appraiser needs to develop a complete understanding of the business’s financial statements, that is, prepare a financial statement analysis of the balance sheet, income statement, and statement of cash-flow. This is a specific skill set that can take years to develop. In addition, accounting rules are constantly changing, thus to understand Generally Accepted Accounting Principles (GAAP accounting), an investor must continuously review and update his/her knowledge of the rules.
To think that a majority of market participants are skilled and informed would be naïve. In fact, the opposite more closely reflects reality. Many investors only possess a superficial knowledge or understanding of how to appraise a business. Financial statement analysis is just the beginning; there is additional quantitative analysis required as well as qualitative issues like business strategy, competitive advantage, management team skill assessment and compensation, corporate governance and board effectiveness, to name a few. Absent a deep understanding of the appraised value or worth of a business, it would be foolish to think that a market participant can bid rationally for shares; ergo, price inefficiency is born.
The astute investor can appraise the worth of a business and exploit the collective unknowingness of market participants by buying when shares trade at a discount and selling when they trade at a premium. This is the secret to financial success when participating in the capital markets. The most important piece of information a participant needs to possess when entering the arena is to understand that the last quoted price is merely a reflection of the day-to-day supply and demand pressure that causes a share’s price to move higher or lower.
From Our Library:
Dear Chairman, by Jeff Gramm, a book about corporate boardroom battles and the rise of shareholder activism, makes unambiguous statements about market price inefficiencies.
…early proponents of the efficient market theory focused on empirical research, it was more like the end of wisdom than the beginning. Economists love to process data, and this lead to critical biases. Their own love of information made them view investing in the stock market as a game of information gathering. They worried more about their assumption that market participants have equal access to information than they worried about collective lapses in judgment.
But it’s easy for investors to get out their calculators and price stock splits quickly and accurately. It is much harder to research investors’ collective judgment of a company’s long-term prospects. For several decades, academic economists took for granted the rational expectations of market participants.
In an efficient market, divergent opinions balance each other out and guide stock prices to an optimal level. In the real world, misjudgments are much more likely to be biased in one direction, and mass hysteria is not uncommon. Even in periods when the stock market is stable, investors are capable of dramatically misvaluing a company.
Having just celebrated our tenth anniversary, I’d like to thank the dedicated members of our team for their continued unwavering commitment to the firm and all of our clients. We recently brought Ms. Stacy Wilke onboard to help manage the firm’s finances and compliance-related matters. Stacy is an alumna of the University of Wisconsin. She has a great deal of accounting experience, having worked with Kohl’s Corporation for over 10 years in store operations with responsibility for staffing, scheduling and training across roughly 1,000 stores. She and her husband Steve live in Cedarburg, along with their two lovely daughters. Our India operation continues to add a truly global dimension to the firm. Mr. Satendar Singh joined us in June and has become a regular part of our daily research and analysis conference call. The India team checks in to our Hyderabad office at noon and works until 10:00 pm, yet still manages to spend five plus hours a day interacting with their US counterparts. We are truly a global firm in many ways.
Memories of the worst day on Wall Street in modern times have been evoked. It was Monday, October 19, 1987; I was 26 years old and less than four weeks into my new career. On this day I sat and watched with disbelief as the Dow Jones Industrial Index (DOW) dropped 508 points in a single trading session. That would be about a 22% decline! This was truly an awesome time in market history and the world was forever changed. New regulations followed. The inevitable sense of growth and well-being were shattered. People on Wall Street as well as Main Street were stunned and suddenly scared.
30 years later, at the age of 56, I still show up to the marketplace on a daily basis to witness the drama and excitement of Wall Street as it plays out in a truly global capital marketplace. Many things have changed, but an awful lot remains the same. The breadth of markets have certainly expanded. More capital flows daily than used to in a year. Markets are global. Trading occurs on a near 24-hour basis. And yet, people seem to have stayed much the same, subject to the emotions of fear and greed, ever hoping for quick fortune and often achieving sudden loss.
I am thankful for this wonderful experience and I am grateful to our many clients, both individual and institutional, who have trusted us to employ our skill and judgment each day as we enter the marketplace. As I’ve said many times in the past, we strive to be the best in our field. The aforementioned only matters if we deliver an excellent client experience. Please feel free to let us know how we can do better. If you’ve had a change in, or would like to update your investment objectives or portfolio restrictions, please let us know so we can make adjustments. We are ever mindful of the trust and confidence placed in us by our clients and will continue to strive to achieve superior investment returns.
Very best wishes,
Your Investment Research and Advisory Team
Global Value Investment Corp.